Still time to move into equities

Jim O’Shaughnessy is pretty confident he has some good news for investors who missed out on some or all of the recent multi-year stock market rally: Equities are positioned to do significantly better than bonds in the coming years, for some fairly obvious reasons.

The simplest reason comes down to math. Following the unprecedented 30-year bond bull market, little room remains for interest rates to move lower and bond prices to climb.

A study by the chief investment officer at Stamford, Conn.-based O’Shaughnessy Asset Management of the worst 10-year periods for stocks showed that the decade prior to February 2009 was the second-worst. Better still, the stock market saw robust returns in the subsequent three, five, seven and 10-year periods — with no exception.

“This led us to conclude that 2009 was the ground floor for equities and investors really need to reallocate to stocks,” he says.

Mr. O’Shaughnessy thinks bond-like equities will be the preferred destination for investors moving out of fixed income, but only value-oriented, financially healthy names with relatively limited leverage should make the grade.

“If you are not financially strong and don’t have the earnings to support your dividend, or if the quality of those earnings is not there, you’re going to take it on the chin,” he said during a recent visit to Toronto.

He believes the recent carnage in bonds and many dividend-paying stocks — sparked by the U.S. Federal Reserve’s comments on tapering its quantitative-easing effots — was driven by sheer panic.

“Typically, those types of things tend to crescendo,” Mr. O’Shaughnessy said. “Then when the Fed comes back and says it might even increase its monthly bond purchases, peoples’ minds will suddenly change again.”

O’Shaughnessy Asset Management manages approximately US$5-billion in assets, including seven funds for RBC Global Asset Management. The largest of those is the $1.3-billion RBC O’Shaughnessy U.S. Value Fund.

The firm’s philosophy is rooted in disciplined and unemotional investing. “I have no idea what the market will do in the next three to six months — none,” Mr. O’Shaughnessy said. “But we can still take advantage of things like inflection points.”

What he does know is the U.S. economy is showing signs of a renaissance: Corporate profits are at all-time highs, the inflation rate is not a problem, and some economists are even quietly worried about deflation.

Mr. O’Shaughnessy is also confident the Fed is committed to doing exactly what it said it would do and will keep near-term rates close to zero until the unemployment rate declines below a certain percentage and inflation does not pose a problem.

His quantitative focus and analysis of previous market cycles leads to some rather straightforward advice for investors.

“The first baby step is an ongoing rebalancing of your portfolio in favour of equities,” Mr. O’Shaughnessy said. “It’s not about security selection or what strategy to use. It’s easy to say, but very challenging to do.”

The emotional overhang of 2008 has left many equity investors so jittery that some naturally panic when a confluence of events — such as tightening in China and fears of the same in the U.S. — occurs.

However, Mr. O’Shaughnessy said a simple rebalancing schedule solves a lot of investors’ problems. Rather than looking out three or six months, he is adamant that investors need to focus on their long-term goals.

For 50-year-olds, that might mean positioning their portfolios for the next 15 or 20 years with retirement in mind.

“It’s all noise on a day-to-day basis,” Mr. O’Shaughnessy said. “When you look over long periods of time, the signal becomes quite strong and the noise becomes diminished.”

The rally in U.S. stocks shows some investors are getting the message, but many others are still on the sidelines.

“When you sell and sit in cash, you’re destroying the value of your money. You may think you’ve taken the safe route, but you’re actually impoverishing yourself,” Mr. O’Shaughnessy said. “We are always going to hit rocky times – that’s the nature of the equity risk premium. Investors with the ability to see them that way are the ones that are going to be able to take advantage of the opportunities they present.”

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